Richard Whelan, financial and international policy analyst, reviews the reasons for the new Depression and tries to see how events will unfold.
This is a journey of discovery and I hope you will join me. I have drawn on international expert commentary and opinion to try to make sense of what has happened to the global and local economy. We have to try to understand what went wrong before we can put it right.
I hope you will read this piece and that it will add to your understanding. I don’t pretend to have the answers, and I’m not sure if anyone yet has. Please leave a comment – take issue with me or add to the discussion.
Richard Whelan, Dublin, April 2009.
- The Economy is Broken – How Do We Fix It? (December 2009)
- The 2009 Great Recession – Updated Comments (June 2009)
Richard Whelan is the author of Al Qaedaism The Threat to Islam The Threat to the World, published in Ireland by Ashfield Press and in Turkey by Platin. He is a member of the International Institute for Strategic Studies and the Belgian Royal Institute for International Relations. For 23 years he was a partner in an international financial services firm.
His website www.richardwhelan.com contains up-to-the-minute commentary and analysis of international affairs.
I believe we are talking about a worldwide depression. A recession that lasts for a number of years is the official definition of a depression, and this recession is likely to last for a number of years at least .
Removing the excess leverage or debt out of the world’s financial system will take approximately five years – based on a number of measurement criteria. In addition it is difficult to see how any consumers could replace the US consumers who kept world demand at such a high level for many years ( It is clear that US consumers will be focused for a number of years on reducing their debt and building up their severely depleted pension investments.) Many think Chinese consumers may be a replacement for US consumers . However if the Chinese government succeeds in stimulating internal demand in China, this will be of use to China itself only. Further in an article titledCapitalism beyond the Crisis Amartya Sen , the Nobel Prize winning Harvard economist said “many economists are anticipating a full-scale depression, perhaps even one as large as in the 1930s” (New York Review of Books, March 26 – April 8, 2009). We are therefore more than likely facing a depression over the next few years.
I intend to try to understand this depression by looking at international analyses and commentary on the current problems and particularly how we got into the current situation.
My purpose is relatively straightforward and is very much not designed to add to panic or to the level of fear in the world today. Only by understanding quite how we got into this mess can we design appropriate policies to get out of it a properly, fairly, and at as early a date as is possible in the circumstances.
From an Irish perspective it is important to put our current position in context. In an analysis dated March 2, 2009,Credit Suisse produced a ranking termed “country risk table“. Ireland came number 14 on the list, after the US at 13, and before Poland at 15. The most at risk country was Iceland at number 1, while the least risky at number 42 was China. In a separate table analysing “country economic flexibility” Ireland came in at number 18, near the middle of the listing of countries. The US was number 1, Switzerland number 6 and the UK number 9. Most of our EU fellow member states came in with lower (worse) scores than us .
These independent statistics indicate that while we have significant problems in Ireland, we are by no means in the top 10 problem countries and we are – interestingly – independently assessed as having a moderate level of flexibility to deal with the problems we face.
What happened and why?
Two initial comments here. Firstly, contrary to what many think, many experts have been warning for some time of the exact problems that eventually struck us so forcefully . The magazine Foreign Policy cited the following early warnings in its January-February 2009 issue to show that yes indeed we had been well warned:
- “Because the US is such a huge part of the global economy , there is real reason to worry that an American financial virus could mark the beginning of a global economic contagion.”- Nouriel Roubini, March 2008;
- “If, as I suspect, the American consumer now enters a sustained slowdown, there will be unmistakable reverberations on US-centric export flows in many major regions of the world.”- Stephen S. Roach, October 2006;
- “The size of the financial markets… has become so monstrously huge, there is no other means of maintaining stability than to establish a psychology of confidence. The governments themselves can only project to the markets a sense they know what they are doing.”- David M. Smick, March 2008;
- “I am worried that the collapse of home prices might turn out to be the most severe since the Great Depression.”-Robert J. Schiller, September 2007;
- “If housing prices fall back in line with the overall rate price level… It will eliminate more than $2 trillion in paper wealth and considerably worsen the recession. The collapse of the housing bubble will also jeopardise the survival of Fannie May and Freddie Mac [The major US mortgage lenders] .”- Dean Baker, September 2002.
Secondly, it is clear that many of these problems arose out of the fiscal/financial/economic solutions adopted to deal with previous crises as I will show below. This second conclusion is important as it emphasises the need to not get ourselves into further difficulties by applying the wrong solutions to our current problems.
There is no identifiable specific starting point for the current crises. However there is no doubt that the response of governments and regulators to the Asian financial crisis starting in 1997 (which hit the US stock market particularly hard, as well as obviously having a major impact in Asia) the dotcom bubble which started to burst in the late 1990s, and the attack on 9/11/2001, led to a concerted effort to avoid recession in the major world economies. This very valid and understandable objective was to be achieved by adopting an expansive monetary policy, particularly by providing incentives to banks to increase credit, to make companies more likely to invest and individuals more likely to consume. Both would help increase demand for world products. The simple tool, initially adopted by the US Federal Reserve, and then by other central banks, was simply to reduce interest rates to historically very low levels.
The US central bank, the Federal Reserve, quickly lowered interest rates to 1%, the lowest level since 1958. For more than 2 1/2 years, long after the US economy had resumed growing, the Federal Reserve funds rate remained lower than the rate of inflation. Simply put this meant that for the relevant banks money was free. At such low interest rates lending to major corporate customers was providing little of the profit banks had made in previous years from such lending. Banks therefore had a number of incentives (free money, the need for alternative sources of profit, etc) to seek alternative ways of making money. This led to a host of unintended consequences not just in the US, but in many countries worldwide where the same financial structures effectively applied for much the same reasons.
In the EU, the European Central Bank (ECB) also kept interest rates at quite low levels, reflecting as much as anything else the policies of the bigger EU members, particularly Germany. This had the consequence of introducing the “concept” if you will to a number of EU states of the likelihood of interest rates staying at low levels for extended periods. This new situation, compared to the previous monetary environment in a variety of countries which had historically experienced higher interest rates, helped fuel some of the attitudes particularly the willingness to borrow, and to leverage business and investment deals, that led to some of the bubbles discussed below.
In addition to the positive objectives of avoiding recession and keeping demand high-adopted by both the US and many other governments worldwide, the US government saw the availability of cheap finance as a way to promote a matter of public policy-making finance available to those who could not buy their own home. This led to “negligent behaviour of a generation of policymakers that sent a simple but radically distortive message to global markets. That message was that the US government would guarantee the rights of Americans to own homes and access credit far beyond their ability to afford those goods in the free market. That a generation of obliging bankers and inadequately sceptical investors were complicit in this assault on market economics shouldn’t surprise anyone”. (Remember the Magnequench: An Object Lesson in Globalisation, by Charles W.Freeman ,The Washington Quarterly, January 2009.) This led eventually to a significant increase in credit advanced to borrowers who could not access credit or could not access it at a reasonable rate, by a whole series of financial institutions, including the major US mortgage providers best known by their nicknames of Freddie Mac and Fannie May.
Many countries in the world copied US banking practices to one extent or another. The logic for this is unfortunately quite clear and very simple. Banks are intermediaries who take savings and risks and reallocate/ reapportion them to various customers to earn a profit. In addition because interest rates were kept low, most Western savers were essentially penalised, and borrowing encouraged indirectly by each government who followed the low interest rate policy. It nominally makes sense for the individual not to save as he/she is effectively losing money at low interest rates when inflation is at a higher level (which it was), but instead to borrow to invest, frequently in property. In simple terms governments worldwide did not change this policy until it was too late.
Each step after this is very simple and very logical. With very low interest rates, and inflation at low levels, but higher than those interest rates, providing effectively free money, borrowing/ leverage soars. It seems to make sense to everyone to borrow. Why save when you only lose on your money?
Taking the US as a good example of what then happened, debt in the financial sector overall increases, personal debt increases and with all the money available and incentives to buy, house prices start to rise. Many banks were not making money lending to their major corporate customers because of the low cost of money, tight margins, greater competition in the financial sector etc. Many banks then set up investment divisions or began “principal trading” or investing on their own accounts frequently with significant borrowed funds. By 2007 it has been estimated that the principal trading accounts at Citigroup, JP Morgan Chase, Goldman Sachs, and Merrill Lynch had ballooned to $1.3 trillion. To use Senator Joe 0’ Toole’s description of benchmarking in Ireland the continued increase in house prices converted their homes, in the mind of many homeowners, into ATMs. This had the direct effect of increasing consumption, as homeowners thought the increase in the value their homes was permanent , and effectively they could spend that increase in value, or use it as equity for further borrowing. In the US, personal consumption accordinglt rose from its traditional 66% /67% of GDP to 72% by 2007, that latter figure being the highest on record.
The broader economic impact of this in the US was a current account deficit of almost $5 trillion in the years 2000 to 2007 inclusive. This deficit was, is in essence, almost all made up of payments for oil and consumer goods.
The US, and many worldwide, believed that a “global savings glut” or as it is strikingly sometimes put a “wall of money” from pension fund and other investments, recycling of oil profits, and savings in Asia, would enable the US to effectively “force” the world to absorb US dollars for decades to come.
Although correct with respect to China (a point I cover below) there were unexpected consequences. The first was that yields began to reduce as cash was being invested in all kinds of assets and constantly seeking better returns. To keep generating good and increasing returns for the huge amount of savings floating around the world, leverage was continually increased in deals; hedge funds were set up with high debt and eventually taking quite high risks; collateralised debt obligations (CDOs) were structured to turn low-quality mortgages into supposedly attractive investment vehicles; insurance of the risk of default (frequently from America’s biggest insurer, now nationalised, AIG) became commonplace ; and inappropriate rating from rating agencies converted high risk financial products (frequently subprime house mortgages) into nominally attractive investments that pension funds (a huge part of the wall of money) could only then invest in.
You now had the lethal combination of a property bubble, a credit bubble, (in other words significant excess leverage or debt ), and a huge volume of financial instruments that no one really understood and no one could value in a threatening environment or in any environment other than the perfect future assumed by many such instruments.
While all this was going on there were many other bubbles building up in many areas of the world and in many products, particularly commodities, notably the price of oil.
Another bubble was also building up at the same time – an unsustainable export bubble, particularly from China and other Asian countries, as well as from oil exporting states, and other major commodity exporters.
The mirror image of the US consumption-generated economic deficit was an economic surplus generated by China principally by its exports to the US. This was “financed” by China’s significantly undervalued currency, a major bone of contention between China, the US and other Western states for much of the last decade. (Other Asian states more quietly also used undervalued currencies to help in their export drive.) To keep economic growth in China at a level that would dampen down internal unrest and dissension, it is now clear that China needs to grow economically by 7% to 8% per annum, otherwise the millions leaving the land each year cannot get employment. In the then absence of adequate internal demand the only significant market that China could tap to meet its economic and political needs was therefore that of the US. By continuing to export to the US and by investing its reserves directly in US government securities and indirectly in Freddie Mac and Fannie May, China in essence helped America “party” through most of the first decade of the 21st century, ” supporting” US consumption and budget deficits.
China also played another key role. Chinese exports were keenly priced and effectively kept US inflation at bay. Had they been more realistically priced, or the Chinese currency not kept artificially low, which amounts to the same thing, central banks would have acted against the ensuing inflationary pressures by raising interest rates. This would have put an end to, or seriously curtailed, the “American party time” splurge. China bears considerable responsibility for our current problems, not least because it forced its citizens to save with domestic banks only, while the state invested the budget surplus heavily in US stocks and bonds. The malign effect of the managed Chinese exchange rate policy on the current state of the world economy is hard to overstate.
In any bubble a day of reckoning has to arrive. History provides proof of that. With so many bubbles expanding at the one time (or to put it another way, a glut of worldwide greed in operation) even a very small adjustment to the assumed perfect future can have a massive impact, particularly in a globalised world with 24-hour media reporting.
Most bubbles eventually burst for predictable reasons, particularly the growing realisation that they cannot continue forever, inflation creeping in, and the cost of funds increasing. This series of bubbles was no different. Significant concerns grew because of the extraordinary increases in commodity prices, particularly oil, and with the onset of the related inflationary pressures, the cost of funds was increased by many central banks. In addition in 2006 in the US, house prices decreased for the first time in a number of years. Although the decrease was only approximately 6% , sentiment began to change dramatically. What was about to happen was significantly magnified by the fact that the credit bubble and the property bubble burst at nearly the same time.
With decreasing house prices in the US, and increasing interest rates, some homeowners very quickly got into arrears with their mortgage repayments. In many cases this would have happened anyway, as some of these products were structured with very low interest rates for a few years and then rates closer to market norms kicked in. Because of the manner in which some mortgage assets had been aggregated, structured, and rated, the impact of very slight changes in house prices and interest rates on some of these sub-prime mortgages was immense. Suddenly supposedly low risk investment products were suffering massive losses which started to weaken confidence in the entire mortgage finance area. This loss of confidence was significantly increased by the great difficulty many banks and finance houses had in actually valuing many of these products. The mathematical models underlying them were complex, frequently assuming continuing price rises, and proved resistant to easy valuation or analysis.
Initially the problem was thought to be limited to sub-prime mortgages and to the US. However it slowly emerged that many of these products, and similar property-based investment products, had been sold on to non-US banks. Slowly but surely the contagion spread until in the summer and autumn of 2007 a full scale banking crisis was occurring. For a period this was again thought to be limited to the US, but very soon it became clear that the balance sheets of many banks worldwide had investments in sub-prime mortgages, or similar products which were now under threat, and difficult if not impossible to value, or extensive loans to emerging markets which would suddenly might not be so attractive. The response by governments and regulators was slow and hesitant, and for a long period focused on increasing liquidity into the banking system. In fact the problem was much more serious, it was a bank solvency crisis and the write off of these difficult-to-value assets and/loans to exposed emerging markets was eventually going to make many banks insolvent. By the time this was realised almost a year had elapsed. Only in September-October 2008 did governments worldwide begin to fully appreciate the horrific extent of the problems facing them and the need to deal urgently with bank solvency issues .
Many overlooked the simple fact that banks are at the core of financial flows in the world and are key providers of credit to individuals, corporations, and governments. When banks lose confidence in the other banks they are dealing with (either because the other banks hold difficult-to-value assets or appear exposed to financial products or markets that are in difficulties) this lack of confidence spreads like a contagion. Many governments were slow to realise how serious this problem was and even that it existed.
Many assumed that the US would be in deep trouble because of these crises. In fact the EU is likely to be much more exposed and slower to recover.
European banks and finance houses have significant exposure to sub-prime mortgages. In addition a number of countries in Europe have gone through significant house price inflation, particularly Spain, Ireland, the UK, Norway, France, and Sweden. Further, although many still do not appreciate this, during the years of excess, or the bubble years, many banks in Europe had been advancing significant funds to emerging markets and emerging countries, including eastern Europe and the Baltic states. Adding to the burden of the normal repayment of loans, many of the loans to eastern Europe and the Baltic states were made in the form of Euro or Swiss franc loans because of the lower interest rates applying to them compared to loans in the local currency. With the collapse of the currencies of some of these countries, not alone have they the problem of paying back capital they cannot afford, they also have the problem of having significantly increased capital to pay back because of the decrease in the value of their currencies vis-a-vis the euro and the Swiss franc. It has been estimated that such loans to Eastern Europe and the Baltic states, a significant percentage of which are now in essence uncollectible, amount to $1.5 trillion.
In the EU, exposure to emerging markets debt is actually six times greater than US exposure to sub-prime debt. As an example, Austria’s exposure to emerging markets is $290 billion, while its GDP is $370 billion. Another weakness in the EU compared to the US is what has been described as the EU’s achilles heel. The US has one central bank-the Federal Reserve. With respect to national banking issues each country in the EU has its own central bank-there is no single banking authority. This makes agreeing any significant monetary policies quite difficult, beyond those mandated to the European Central Bank. In essence a “one size fits all” approach might be reasonable in normal circumstances, but is a distinct disadvantage in the crises we face today. In addition the EU has much lower labour mobility than the US and very poor fiscal transfer mechanisms, while because the dollar is treated as a reserve currency, the EU is quite vulnerable to foreign capital withdrawals particularly in times of crisis.
In both the EU, US, and other countries a number of other factors helped turn the multiple bubbles bursting at approximately the same time into the first truly global recession, and eventually world depression.
New accounting requirements to “mark to market” (assets marked down to the current market price) various investment products significantly worsened the bank write-offs at exactly the wrong time. In many cases there was no proper market, or if there was a market at all the write-offs on some worthless sub-prime mortgages “tainted” baskets of investments including some such assets, leading to some inappropriate losses being taken. To put this in context the International Monetary Fund (IMF) predicted that there would be approximately US $1 trillion in “mark to market” losses eventually. (The IMF was set up to manage the world financial situation in the aftermath of the Second World War. )
In many countries, the various restructuring activities undertaken by banks to boost profits during the credit bubble, effectively set up a “shadow banking” system. This included the hedge fund operations (using aggressive investment tactics particularly leverage), significant off-balance sheet vehicles, and a variety of unregulated markets in derivatives. In many cases what happened, particularly with sub-prime mortgages, was that the originator of the loan was separated deliberately from the bank that eventually funded it. This made many originators negligent with respect to ensuring the mortgage would be repaid. It also meant that over time a significant part of the banking/financial system that developed out of these practices was actually almost totally if not fully unregulated by governments.
One other factor explained the slow reaction of governments, central bankers, and regulators to the evolving crises. This was the belief, widespread amongst each of these constituencies, in the “efficient market theory”. In essence this theory postulated that markets, left to their own devices, would eventually return to an appropriate stability. This belief was quite explicit amongst many in the US, but was also implicitly accepted by many outside the US – a much more dangerous situation. The combination of this belief, and the extraordinary fact that most central banks and regulators did not see that it was part of their formal role to control bubbles – be they of property or credit-allowed the problem to spiral out of control. George Soros writing in the New York Review of Books pointed out that “markets can be self-reinforcing on the downside as well as on the upside”. The bubble up can turn into the bust going down, with little limit. We are learning at present how accurate this statement truly is.
In the magazine-Foreign Affairs in its March-April 2009 issue , an article titled The Japan Fallacy by Richard Katz, summarises what went wrong in the US. Much of what he says applies worldwide.
He attributes the current mess to three basic mistakes:
1. The US refused (and it was a refusal, many efforts were made) to regulate sub-prime mortgages.
2. The failure to regulate the compensation of chief executive officers (CEOs). Many CEOs had compensation packages, particularly stock options, which gave them massive incentives for taking risks, as the upside generated huge returns on the stock options, but if things went very badly wrong they still got the basic remuneration package — only the stock options carried no value. In essence this incentivesed very strong , powerful people to take increasing risks- which needless to say they did. (Although Katz does not mention it, this risk incentivision was much worsened by the requirement for quarterly reporting in many public companies.)
3. The virtual non-regulation of the derivatives market. Initially derivatives were set up to manage risks in for example the corn and other basic/ commodity or real markets. Financial engineering on the part of the banks, hedge funds , and other in the bubble years changed many such useful products into very different and dangerous financial products; these amplified shocks when things went wrong, turning them into “financial weapons of mass destruction” as Warren Buffet brilliantly described them.
Many of these new financial derivatives had no open market or exchange valuation (as the normal commodity and other derivatives had) but were bilateral deals. What this means is that if the “other party”to a deal goes out of business or gets into financial difficulty, the holder of the derivative becomes extraordinary concerned about the ability to collect on the deal, and even on the amount collectable itself. (In other words, the point made above about how to value complex financial instruments becomes a key weakness, putting significant uncertainty into the system).
Taking this last point, as soon as Lehman Bros went out of business, a huge number of banks and finance houses were threatened because they held these instruments and either could not value them or had to write them down to zero, in a “mark-to-market” exercise. Eventually the biggest insurance company in the world, AIG, has to be rescued before the whole system collapsed. At this point the financial problems started to hit the “real world”, not just Wall Street or the financial world. The doomsday scenario suddenly arrives – companies cannot borrow, savers lose money, pensions lose value or become valueless, there is a run on the shadow banking system, and confidence vanishes in the stroke of a pen.
To explain George Soros’s point in another way, the multiplier effect means that if you lodge €1,000 to a bank, it can advance up to €10,000 by way of loans etc. to its customers. What many are only now beginning to appreciate is that this multiplier effect operates on the downside as well, particularly as all investors and other financial institutions are deeply suspicious of many of the new investment securities. This negative multiplier effect in a significant financial downturn sets up a downward spiral soaking up credit and confidence as it goes. This of course is exactly what happened
Although many in Ireland like to blame local villains for what happened (particularly bankers and property developers) Ireland was always going to be hit hard in this situation. This is because Ireland has been one of the most globalised and open economies for many years meaning that any downturn in worldwide demand and consumption would lead to a significant erosion in Ireland’s exports. In addition Ireland was experiencing significant property and credit bubbles. These three problems were magnified to some extent by a specific government policy on boosting savings (Special Savings Accounts), which, when they matured in 2007, put significant extra liquidity into the country. Ireland was also exposed to the fact that a significant element of holdings in its stock exchange and government bonds were in foreign ownership, meaning that the withdrawal of that capital when confidence was lost in the country would have a significant adverse effect at precisely the wrong time.
As in some other countries , the property bubble in Ireland was worsened by the availability of low (in historic terms) interest rates because of Ireland’s membership of the euro. This led many to believe that interest rates would remain low long-term and therefore made borrowing a safer bet than it had been in the past.
Other Irish weaknesses, which added increased pressure to the system, include:
- 20% of exports going to the UK giving Ireland a huge competitive disadvantage because of the change in the euro/ sterling exchange rate;
- Ireland’s financial sector having an extremely high exposure to the property and construction sectors – 77% of bank loan books related to property/construction in 2008, compared to 39% in the year 2000. ( Comparable figures for the US are – 57% in 2008 compared to 45% in 2000); once-off property-related tax revenues (capital gains tax and stamp duty) accounting for about 15% of total government revenue (4% of GDP) with these taxes naturally falling dramatically in this situation.
This last point has led to one of the most difficult structural issues Ireland faces. Having come, in the recent past, from a position of relative poverty compared to many other countries in the EU, Ireland tried to catch up dramatically during the “Celtic Tiger” years . Much of this effort, attracting high-tech, pharma, and other “leading edge” industries was and is a highly successful. Then the various bubbles started to operate on top of this growth. Ignoring what had happened to the “Asian tiger” economies, Ireland took once-off revenues from the results of various bubbles (particularly property -related tax revenues) and used them to fund significant fixed entitlements, through expansion of the public sector, increases in social welfare and related payments, and through a process called benchmarking, to provide significant salary increases to the public sector. This had the obvious effect of increasing Ireland’s cost base dramatically, thereby reducing its competitiveness. For any country this is a problem. For a country such as Ireland which is unusually open to and dependent on foreign trade, it was a disastrous policy choice and one that had to go wrong at some stage.
In Ireland a small number of individuals called attention to the dangers of the property and credit bubbles. However a significant number of commentators, economists, and business people also drew repeated attention to Ireland’s increasing cost base, its declining competitiveness, and how serious this could be for the country in future. When all this came to pass, the small number of individuals who warned about the credit/property bubbles were lauded, while the large numbers who warned of the competitiveness problem were almost totally ignored. This may be simply because facing up to the competitiveness issue requires significant remedial action, particularly with respect to the excessive pay, entitlements, and pensions in the public sector (compared to the private sector) and social welfare entitlements.
Ireland has an open economy, and as a member of the euro (which means it cannot devalue its currency – the usual solution to this type of problem), so this competitiveness problem will not go away. International commentators, financiers, and bankers are well aware of Ireland’s exposure and the need to take drastic action in this area. Credit Suisse in March 2009 , ranked Ireland’s competitiveness in the EMU as second worst after Slovakia. This is in part illustrated by the sharp deterioration in Ireland’s current account position from a surplus in 1998 to a significant deficit in 2008. Of the EMU countries , Ireland was seen as overall the second most vulnerable to significant financial difficulties (after Greece), principally because of the size of its budget deficit, the extent of foreign ownership of its assets, having the highest level of credit (corporate and private) relative to GDP, but mainly for having the most overvalued currency i.e. being the worst in terms of trade competitiveness.
There is considerable debate in Ireland about the Lisbon Treaty which Ireland rejected in 2008, and its predicted impact on Irish sovereignty. It is ironic that the considerable loss of sovereignty Ireland has already experienced because of policy decisions made impacting on its competitiveness and financial and monetary stability, is utterly ignored. Foreign commentators are very clear that there has been a loss of national sovereignty in some EU countries, including Ireland because of these developments. The extent of that loss of sovereignty will only be established in the future, and will be partially determined by the Irish response to the crises.
However Ireland faces these crises in a stronger position than many think. One clear statistic that stands out is that Ireland’s government debt to GDP ratio at 41% leaves it in a strong position, compared to many, to borrow to cover short-term difficulties. Obviously a loss of confidence in Ireland’s willingness and ability to deal with these issues will, and already has, increased the cost of such debt.
Further, as mentioned above, In an analysis dated March 2, 2009, Credit Suisse produced a ranking of countries termed “country risk table“. Ireland came number 14 on the list, after the US at 13, and before Poland at 15. In a separate table analysing “country economic flexibility” Ireland came in at number 18, near the middle of the listing of countries. The US was number 1, Switzerland number 6 and the UK number 9. Most of Ireland’s fellow EU member states came in with lower (worse) scores than it.
As we are dealing with a unique worlwide event there are no easy solutions and no available templates. The world economy of 2009 is very different from the world economy of 1929, when the Great Depression started. The Japanese recession of the 1980s and 1990s was very much focused in that country alone, and, because of many features unique to Japan, has limited lessons for the current crises.
An article in the magazine Foreign Policy, as mentioned above, compared the current crises in the US to the depression in Japan, to show the significant differences between both. There are therefore no truly comparable precedents to draw definitive lessons from. Many confidently state how to deal with these crises. It is crucial to understand that there are no real experts, we will have to make it up as we go along.
In many countries worldwide citizens criticise governments for not dealing clearly and quickly with the issues. However as the Financial Times newspaper and the Economist magazine have made clear no one yet knows the answers, and we will all have to “learn as we go”. The biggest concern for governments is what happened during the Great Depression in the US between 1929 and 1933: national income in the US declined by 30%; there was significant unemployment; and worldwide significant political instability ensued. Most governments have not explained to their citizens how serious this depression could be in terms of the possible reduction in real incomes, which could be quite substantial.
If governments did nothing there would be a significant recession, which if nothing else would eventually clean up the mess. However the toll of such on the population of the world, business, and the economy would be extraordinary severe. This option is not open to any government other than totally despotic ones, and even they must fear what public reaction might emerge. An important issue is the extent of reform and change governments will recommend and people accept. Drawing one relevant lesson from the Japanese recession, it is clear that an absence of structural/government reform delays recovery significantly and spreads the pain over a longer period of time than is really necessary.Delay also worsens unemployment, wealth creation and social dislocation. Some EU countries are likely to behave like Japan in terms of their unwillingness to challenge vested interests and established poor practices by seeking significant structural reforms.
Countries prepared to take reform and restructuring “on the chin” now are likely to experience a sharp shorter shock, and then recover relatively quickly. The US is most likely to lead the world here. Many may see deflation as a simple solution to a wide number of problems, particularly competitiveness issues. However governments will be aware of the possible “triple whammy” problem facing economies facing into these crises today. With economic stagnation and deflation, and with aggregate demand falling locally and worldwide, nominal interest rates will inevitably be set near zero. Three traps then beckon the unwary;
- The liquidity trap: as interest rates are set so low, it is impossible to further stimulate the economy as nominal interest rates cannot go any lower.
- The deflation trap: as prices decrease, real interest rates actually are very high, which kills off any possible growth in consumption and investment. Job losses continue and demand reduces even further.
- The debt deflation trap: in these circumstances the real value of debt actually increases. This is significant bad news both for individual and corporate creditors and also for the US and Japan who have high debt percentages to GNP.
On top of this as governments pour funds into fiscal stimulation, doubts grow in the market about the creditworthiness of those governments. With the demand for funds being greater than the supply of money potentially available, real interest rates tend to increase, providing a brake on the economic development and stimulation required. This also tends to occur as markets increase the risk rating of those governments leading to an increase in the interest rate they pay.
Another significant restraining factor with respect to government policies is the impact the various crises have had on personal pension investments. Certainly in the West, the majority of the citizens of many countries are not in state pension plans, and either directly or indirectly, have to fund their own retirement. Underlying pension investments have now decreased in value significantly, and as the original valuations were in many situations “bubble valuations ” it will take significant time to recover their value, if ever. In some countries bank shares form a significant part of pension fund investments, as they were deemed very safe and secure “blue-chip” stocks. Those investments in bank shares are very unlikely ever to recover most of their value. For example in Ireland where many have invested a significant percentage of their pension funds ( both personal and corporate) in bank shares, it has been estimated that almost all pension funds have declined significantly, anywhere between 25%and 50%. These investments have now got to be rebuilt. With governments under significant monetary and fiscal pressure, many private pension funds will feel the need to invest even more in pensions going forward, as well as to fund the losses incurred recently. This means less funds available for consumption and investment and therefore less economic growth .
On top of this most countries face the serious problem of an ageing population. In many cases this occurs against a background of a declining population overall, while the numbers in the working age cohort of the population are declining dramatically. This structural imbalance is hitting many EU states already, and has been a significant problem for Japan for the last decade or so, and is about to become a massive problem for countries such as China and Russia. Because of their careful use of immigration and demographic trends in that country, the US does not have an ageing population problem. Ireland’s ageing problem is somewhat deferred so it has more time to deal with the issue than many of its EU fellow states.
Thus many countries worldwide (with the major exceptions currently of India and the US) have a significant pension crisis in the private sector, while the public sector cannot afford to continue paying pensions at today’s levels, suggesting either social welfare reductions in this highly sensitive area or less funds available to stimulate economic growth, or both .
These are just some of the main issues governments face in attempting to deal with these crises. The problem essentially is that with excess leverage, significant bubbles in a wide variety of areas, and significant economic growth over much of the last decade in many countries, what the world effectively did was shift GDP increases from the future back to the present. The problem now is that bill has to be paid for which means reduced GDP (economic growth) in the future. Many governments have not explained this unpalatable fact to their citizens.
Dealing with the aftermath of of these major events will require significant structural adjustments politically, economically and financially.
- The IMF needs to be fundamentally restructured. At present IMF membership is essentially based on a post-war deal between the US and Europe. Europe gets to head the IMF while an American heads the World Bank, which provides capital for economic reconstruction. A new deal needs to be arrived at between the major economic powers in the world today, reflecting the much stronger economic muscle of China, India, Brazil, Russia etc. Such needs to be formally agreed and the IMF restructured and capitalised further by the members to help individual countries deal with the current crisis.
- China needs to restructure its economic model. There are a wide variety of important issues here. The more important is that China is now going through a massive restructuring to focus its economic development on internal (and internally generated) demand and shifting its focus from exports, particularly to the US. China (and other Asian economies in a similar situation) must let their local currencies float, rather than holding them at unreasonably low levels, and commence borrowing in their own currencies, rather than the US dollar.
- The US needs to modify the American dream. The American dream of widespread home ownership and ever-escalating consumption, fuelled by debt, has now turned into a nightmare. Under a reforming president the US needs to recast this dream to support the current effort by the citizens of the US to reduce their debt burden. This is likely to continue for some time and needs government policy and fiscal support particularly with respect to home ownership and private pension plans. When the US economy starts to grow again carefully designed policies on mortgage lending need to be in place, policed by capable regulators.
- Europe needs to slowly reduce and restructure its welfare state burden. Particularly with an ageing population in most European states, there is an urgent need to commence the task of slowly reducing welfare entitlements, deferring the age of retirement (to match increased longevity), and ensuring that all entitlements are means-tested. The conclusions from an article on the US but of broad relevance, summarises the action needed: ” A critical implication of these facts is that such domestic policies as means-testing social security and Medicare [health benefit] payments, raising the retirement age to reflect increases in life expectancies, maintaining largely open immigration policies to help keep the United States median age relatively low, encouraging individual behaviours that result in better personal health, and perhaps above all restraining the rising cost of its health care system are critical international security concerns” – A Geriatric Peace ? the Future of US Power in a World of Ageing Populations , by Mark L. Haas , International Security, summer 2007. These conclusions are reinforced in a recent book – The Age of Ageing: How Demographics Are Changing The Global Economy and Our World, by George Magnus, John Wiley. Magnus also points to the need to persuade even more women to take up paid employment, to push for even greater productivity, and finally to help persuade people to save a lot more for their old age.
- Regulators worldwide must broaden their role to cover “shadow” banking activities and accept the role of stopping bubbles getting out of hand. The entire banking industry must be regulated, including non-product-based derivative trading. Although difficult to accept , at present most regulators do not see stopping bubbles get out of hand as part of the role. Such action should be legally set out as their core role, with appropriate high-level professional staff recruited to effect same and there oversight role in the entire banking industry and on derivatives.
- The relatively recent massive reduction in world poverty and increase in the middle-class should not be reversed by ill-advised policies. Although seriously underreported, and likely to be quickly forgotten, there have been many positives from the economic development the world has gone through in the last two to three decades. The middle-class has been the fastest growing segment of the world population in that period. In addition the greatest movement in mass poverty – downwards – has occurred in that period . The percentage of those living in extreme poverty in 2008 (defined as living on less than US$1 a day) was 20% of the number in 1960, a decline of 80%. The income of the average citizen of the world in 2008 was three times what it was in 1960, in real terms. It would be a massive tragedy and a major blow to all those in Asia, the Americas, and parts of Africa who have at last emerged from poverty and into the middle-class if we were to “throw the baby out with the bathwater”. Looked at from this perspective, and drawing appropriate lessons in the circumstances from the Great Depression, it is vitally important to stop protectionism, to not strangle the economic/financial system, to cut red tape and bureaucracy, and finally to ensure that development strategies continue with the successful policies adopted in the past that led to these successes.
- A change of guard is needed in most countries. In the US with the new administration comes not just new political figures but also new leaders of many departments of government. This is valuable in that the various crises can be evaluated anew and action taken without trying to defend previous decisions or mistakes. The harsh reality is that in most countries senior politicians and senior civil servants are the ones who got the world into the current problem. It is difficult in most cases for the same individuals to have the intellectual honesty, credibility, and commitment to take the appropriate action to deal with these crises. Such is particularly difficult where these individuals have benefited directly from the policies adopted and the policy mistakes they made. Even changes in government will not deal with the issue here as in most countries senior civil servants have not been sacked for the errors made during the bubble years.
Bank shareholders and executives and private pension schemes
The biggest losers are likely to be bank shareholders . The IMF has estimated that eventually banks will write-off US $1.5 million of assets, of which 50% had been reported by November 2008. While some bank executives will escape with significant bonuses, most will not, and as significant shareholders because of bonus, incentive and other compensation schemes, they will share in the appalling attrition in bank shares that has occurred, and is very unlikely to be reversed even in the medium term. This has and will have a significant impact on private pension funds. In addition the significant reduction in personal pensions coupled with improved life expectancy will keep these schemes under pressure for many years. The “good times” for bank shares and executives are well and truly over.
Despite all that has occurred there are still significant savings available worldwide, sitting on the sidelines waiting for certainty or a return of confidence or both. For example there is at least US $6 trillion in global money markets waiting for investment. Undoubtedly when confidence returns and much of the uncertainty is removed these funds will be invested. However because of the usage of leverage to increase investment returns in the bubble period, it is likely that in the absence of such the overall return to savers will be lower.
Emerging markets/industries with excess capacity
Emerging markets relying on manufacturing for global consumption will be badly hit as will the currencies of high exporting countries. Countries which invested in significant extra physical capital to meet increased global demand will clearly have significant difficulties. In specific terms industries with significant overcapacity, e.g. car manufacturing, are going to be particularly badly hit and are unlikely to recover the position they had before the bubbles burst.
Because of the reduction in global demand, commodity producing countries will be seriously hit. Such countries are likely to include the Middle East/ Gulf states, Canada, Australia, Russia, Brazil, many countries in South America (particularly Argentina), Africa, Venezuela, Ecuador and Iran.
Countries that have eroded their competitiveness and must compete
A number of countries have adopted a variety of policies that have significantly eroded their competitive position. They include. Slovakia, Ireland, Spain, Greece, the Netherlands, Italy, Portugal and France. Where this loss of competitiveness is significant and the need for external trade high, this will take some years to remedy and require significant remedial action. Such is particularly an issue for Ireland, Greece, Spain, and Italy.
There is significant debate about whether China will be a winner or a loser. On balance I believe it will be a loser, as much because of its significant demographic weaknesses (considered in a variety of articles on my websitewww.richardwhelan.com) as well as the fundamental restructuring it has to go through to shift from an export focus to the generation and meeting of internal demand. The level of internal unrest in China is extraordinary high at present and with significant unemployment already occurring and more likely the potential for significant unrest is quite high.
There are a number of different issues at play here. It has been clear for some time that with significant declining populations in most countries, and a significant ageing of those declining populations , the existing burden of pensions specifically and social welfare in general cannot be borne in the medium term. Significant reductions in social welfare entitlements, and in particular the index linking to dependency ratios, will have to occur. Such is the case already in Germany and Japan. In the medium term few European countries can avoid following their example. In addition some countries of central and eastern Europe and the Baltic states have left themselves seriously exposed to the crises we have analysed above, on top of declining (in some cases quite significantly) and ageing populations. These countries will have significant difficulties over the medium term. (See the paper on my website www.richardwhelan.com in this regard Europe’s Destiny Is Not Necessarily Shared by the US, February26, 2009 ). For a whole variety of reasons, covered here and elsewhere, Ukraine will be particularly vulnerable.
The world overall
The March-April 2009 issue of the journal Foreign Policy focused on the implications of the current crises, describing the upcoming period as: The Axis of Upheaval. Having looked at the major implications of what has happened, it had no doubt that globalisation would continue; it saw the likelihood of much more Great Power Politics (this in fact had been occurring already); and significant upheaval and volatility because of the financial/economic problems, as occurred in Europe in the 1930s after the Great Depression. It also mentioned the “usual suspects”, particularly Russia, Iran, many states in Europe mentioned above, and others such as Argentina and Ukraine. It also included Mexico as a likely very unstable country pointing out that the numbers killed in the drug insurgency there in 2008 were greater than all the US deaths in Iraq.
The US and market economies
Those who reform fastest and deepest and those who reverse the policies that created these problems, will emerge quickly and more strongly than anyone else. The US, with its new administration and new senior civil servants, is likely to firstly fully and properly identify the problems (as they did not cause them), try different policies to reverse them, and then undergo deep and lasting structural reforms to keep their pre-eminent position worldwide. In a “learn as you go” situation, political leaders and civil servants who are not burdened by their past failures can perform best, can try different alternatives, and then speedily make changes. The US will undoubtedly be first in these areas. It will be the first to remove the significant uncertainty in its economy at present, restore confidence, and therefore recommence economic growth earlier than anyone else.
It is also clear that no satisfactory alternative exists to a well controlled and regulated market economy, despite recent appalling experiences. Here’s one pertinent view. “However, it would be premature to write off Wall Street’s primacy in world financial markets. It is also useful to note what has not happened. In a financial crisis money typically pours out of the affected country and its currency collapses. But as America’s banking system was paralysed and its stock market plunged, the ‘ flight to quality’ was not to some other country, but to US Treasury bonds. The credit of the US government was still seen as trumping all others. In any case, other countries lacked the range of investments and deep markets that could provide alternatives. That should give those who forecast America’s imminent demise pause for thought… The American economy, moreover, has in the past shown remarkable ability to bounce back from adversity.” (The Importance of the Financial Crisis, by Alexander Nicoll,Survival, International Institute for Strategic Studies, London, December 2008-January 2009).
Subsequent events do not change my views. Just as the US tightened regulation considerably after previous scandals and problems (a perfect example being the Sarbanes-Oxley legislation), tighter regulation today together with significant reform will eventually boost confidence in the US, its markets, and its economy. This is likely in the short to medium term. There is one very large cloud on the horizon for the US however. A number of experts have been and are commenting on the fact that the US dollar itself is going through a bubble and this will eventually go badly wrong. As the world’s reserve currency, the US dollar can and does play by different rules. However economic and financial reality usually catches up in these situations. The key question is whether the current administration in the US is capable of significantly restructuring the US economy (so the US pays its own way) to eliminate the possibility of this bubble bursting. Significant government spending, and pumping even more US dollars into the system, without addressing the US deficit and other structural issues in the US economy, heighten the risks here.
After the worldwide failures in regulation clearly massive resources and effort will be required to ensure it does not happen again. This will require appropriate legislation, and senior staffing in regulators’ offices worldwide. The key will be the regulator or the appropriate government department accepting the role of ensuring that bubbles do not get out of control. One of the most difficult areas will be to draft legislation, and appropriate regulatory tools, to keep leverage, and derivative financial products, at appropriate levels and/or properly structured.
Strictly globalisation will not be a winner, just not a loser. Globalisation will continue, with some further controls on its financial activities in particular. However the developing interrelationships in an internet-driven world will not be undone. In most cases, particularly with respect to cultural, social, media and related matters, its impact cannot be reversed anyway. We live in a interdependent world , and that will not be undone by temporary dalliances with protectionism. (A classic example of such interdependency is the fact that Japan and China both hold more than US $.5 trillion of US Treasury securities at present.)
After bubbles, markets always overshoot on the downside, just as they previously did on the upside. It is therefore likely that in many markets house and asset prices will decline too much, giving profitable opportunities to those with the courage or confidence to act when all around them are still paralysed by fear or indecision.
What the world went through between approximately 2002 and 2008 was not a “normal ” period of economic or financial activities. In fact it was completely “abnormal” in historic terms. From 2008 until around 2015 the world will be going through a transitional or adjustment period to undo the impact of the bubble years. From that date onwards (and that date is very uncertain) the world will be going through a new normal, but clearly unique, period. The world will certainly not go back to the way it lived in economic and financial terms during the bubble years. It is crucial to understand that fully.
Government policies in the US and much of the rest of the world set out with the good intention of avoiding recessions and the related unemployment and social dislocation. Incentives were left in place unchanged long after their objectives had been realised, and the subsequent market distortions, with an absence of proper regulation, eventually allowed greed to take over. This was reflected in increased leverage in all kinds of financial products and investments, the conversion of many new financial instruments, particularly derivatives, into “financial weapons of mass destruction”, and the – eventually lethal – separation of the originators of certain financial products (particularly some sub-prime mortgages) from those who eventually held them. Add to that toxic brew the appalling performance of rating agencies, the widespread belief that the ” good times” would last forever (“justifying” enormous loans to emerging markets, particularly from Europe), and the credulous belief in the efficient market theory, and the consequence has to be a series of bubbles. When no one cried stop, at a sufficiently senior level or sufficiently loudly, the crises had to occur, which they duly did. To be frank many knew it was just too good to be true, but there is a widespread reluctance to say that “the Emperor has no clothes”, as Hans Christian Andersen reminded us.
The extent of dislocation or adjustment can be looked at from a number of perspectives. From one perspective, I understand that it does take up to five years to remove excess leverage (borrowing) from the financial system. From another perspective, the world effectively took future GDP and enjoyed it in the present. That is now behind us in the bubble years, and the future years will be all the leaner for that. The difficult adjustment period the world faces will be heightened by the fact that many countries will have to begin to face up to the serious demographic issue of declining and ageing populations that now threatens them. Dependency ratios will worsen, the numbers working will decline relatively, the burden of the paying for the aged and healthcare will increase, and social welfare payments will need significant restructuring and reduction.
Those who reform fastest and deepest will come out of this adjustment faster than anyone else. With a new administration, and unusually positive demographics amongst the Great Powers, the US, surprisingly, is likely to lead the field. The EU, which for extended periods did not see the looming threats, is likely to be much slower, for a variety of reasons set out above, and because of its negative demographics and what might be termed its declining (relatively) geostrategic ” footprint ” in world terms. China is likely to have a difficult adjustment period, while both it and the US will learn many new and unique lessons about interdependence in our globalised world. Russia, Iran, Venezuela, Ukraine, and a number of other states mentioned above, face difficult times. In terms of political instability, in addition to the countries mentioned here, a number of states in Eastern Europe and the Baltics at the moment look particularly exposed. The role of the EU in this regard, and with respect to the weaker EU member states mentioned above, will be crucial. I am not sure that the EU has fully realised this yet.
The major ” wild-card” is the possibility of a US dollar bubble, if the US government continues to pump dollars into the world system, without fundamentally restructuring its economy to remove, even over the medium to long term, its current-account deficits and over-borrowing. If this was to occur, or the move to a new or different reserve currency arrangement be mishandled, the effects would be extremely severe and widespread.
One of President Barack Obama’s favourite philosophers, Reinhold Niebuhr (1892 – 1971) writing in his famous book The Irony of American History in 1952, foresaw the danger of an excessive pursuit of gratification and many of the issues we face today. “The lip service which the whole culture plays to the principles of laissez-faire makes for tardiness in dealing with the instability of a free economy … Some believe that … a recurrence of such a catastrophe [ the Great Depression] is impossible; but it is not altogether certain that this is true.”
He then summarises how we might approach our current problems: “For man transcends the social and historical process sufficiently to make it possible and necessary deliberately to contrive common ends of life, particularly the end of justice. He cannot count on inadvertence and the coincidence of private desires alone to achieve common ends. On the other hand, man is too immersed in the welter of interest and passion in history and his survey over the total process is too short-range and limited to justify the endowment of any group or institution of “planners” with complete power. The “purity” of their idealism and the pretensions of their science must always be suspect. Man simply does not have a “pure” reason in human affairs; and if such reasons as he has is given complete power to attain its ends, the taint will become the more noxious.”
“The controversy between those who would “plan” justice and order and those who trust in freedom to establish both is, therefore, an irresolvable one. Every healthy society will live in the tension of that controversy until the end of history; and will prove its health by preventing either side from gaining complete victory.”
– The Irony of American History, by Reinhold Niebuhr, with an introduction by Andrew J. Bacevich, University of Chicago Press.
- Why a Complete Rethinking of our Political Economy is Necessary (April 2010)
- The Economy is Broken – How Do We Fix It? (December 2009)
- The 2009 Great Recession – Updated Comments (June 2009)